UK Real Estate Market Commentary – December 2015

15/01/2016

Economy

Schroders expects UK GDP to grow by around 2% p.a. through 2016-2017, in line with its long-term trend. Last year finally saw an increase in productivity and, if that is sustained, it should support a steady increase in real disposable incomes and consumer spending over the next two years. In addition, we expect the Bank of England to adopt a cautious approach to raising interest rates, partly because the slowdown in China will restrain inflation, but also because of concerns about the impact of cuts in government spending in 2016-2017.

Occupational market

Although prime office rents in London and certain other markets (e.g. Bristol, Cambridge, Manchester, Reading) are now above 2007 levels, we expect them to rise further over the next couple of years. Demand should continue to benefit from growth in professional services, IT, media and serviced offices and a lack of development finance, while strong competition from residential developers is likely to limit new supply and keep vacancy in check. It is estimated that over 10 million square feet of second hand office space has been converted to residential since Permitted Development Rights (the ability to change use from office to residential without requiring planning permission from certain Local Authority) were added to the planning system in May 2013 (source: British Council of Offices). The notable exception is the City of London, where a clutch of new office towers could lead to an oversupply in 2018-2019.

Despite the general air of optimism among consumers and brisk sales, retail rents outside London have barely moved over the last three years. The real challenge is the rapid growth of mobile and online sales, but some retailers are also migrating to smaller stores, following a period of over-expansion before the financial crisis. The main positive has been the growth in casual dining and restaurants which now account for 20-25% of space in some shopping centres. While the introduction of the living wage may depress profit margins, we are more concerned that mid-market restaurants are approaching saturation and that some concepts may fail.

Over the long-term, industrial estates have seen slightly faster rental growth than big distribution sheds and last year maintained the pattern. Industrial estate and big shed rents rose in 2015 by around 5.5% and 3.5%, respectively (source: IPD Monthly Index). While both are benefiting from the growth of online sales and express parcels, new development of big sheds is increasing at a higher rate due to pre-letting, lower build costs and increased capital available for speculative development. Consequently speculative building of big sheds doubled in 2015 (source: PMA) and accordingly we prefer industrial estates which, outside London, also have the advantage of higher yields.

Investment market

The balance between demand and supply in the UK investment market has weakened since the summer, although total transactions are a near record £60 billion in 2015. On the demand side, the queue of international capital waiting to buy UK real estate appears to have shortened, although domestic interest remains broad-based. While the decline in equity has to some extent been offset by an increase in debt, the latest figures from De Montfort University suggest that new lending is still running at only half its 2007 level. On the supply side, a number of investors who bought in 2010-2011 are now looking to sell, partly in order to crystallise their gains, but also perhaps because of renewed confidence in the eurozone.

As a result of less intense competition amongst investors, the IPD all property initial yield has settled at around 5%. Although that is low by historical standards, it is 3% above the yield on 10 year gilts and the risk that gilt yields might rise significantly in 2016-2017 appears to have receded. Schroders’ base case is that while yields on regional offices and industrials might fall a little further in 2016 and supermarket yields will probably rise, yields on most real estate will be broadly flat.

Outlook

It is difficult to see what might trigger a downturn given that the economy is expected to continue growing, development is at a low level, lending is relatively restrained and future increases in interest rates should be gradual. Schroders’ is forecasting total returns of around 5% p.a. over the five years to end-2020, equal to the income return. We expect industrial to be the strongest sector (7% p.a.) and retail the weakest over this period (4% p.a.).

The main risk to this forecast is the EU referendum which is likely to be held later this year. We expect the UK to stay in the EU, but there could be a hiatus in occupier and investor demand before the referendum, particularly if polls suggest a close result. Conversely, if the UK leaves, then parts of the market could experience capital and rental value declines, with the City of London and London residential potentially at greatest risk.

The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

For professional investors and advisors only. This document is not suitable for retail clients.

This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Real Estate Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.

Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and may not be repeated. Investors may not get back the amounts originally invested.

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